Muniwiseguy

Wrong-Way Newspaper Articles Have Hit Hard

Wrong-Way Financial Bets Have Hit Hard (Wall Street Journal Page C1 - July 8, 2010)

The Wall Street Journal ("WSJ") ran an article on the front page of the Money and Investing section titled "Wrong-Way Financial Bets Have Hit Hard" (see the post script for the link to the online article), which is riddled with fallacies.  I am under no delusions and realize that anything I say, no matter how true, will be a mere whisper in the nose-bleed section of a Metallica concert compared to the WSJ's reach.  Nevertheless, I just can't bear to read such a biased article without standing up and speaking the truth to all who will listen.

A reader with no background knowledge was likely left with mental images of a nefarious investment banker in a black pin-striped suit grasping a bleeding IV in one hand, that was just ripped out of the arm of an elderly patient in the ICU, and a stack of "contracts" in the other.  Another image that may come to mind is a huddle of these banksters over a roulette wheel taking "bets" from their clients, while grinning at the thought of making their vig.  Those mental images conjured by Mrs. Dugan are just the kind that sell newspapers.

The article describes interest rate swaps executed by various hospitals (and health systems) across the country.  While the article fails to name the exact product (likely due to the author's ignorance of the subject), it is clear by the description that it is a floating-to-fixed rate swap.  The article is unambiguous in its characterization of these transactions as speculative through the use of such terms as "wager," "bet," and "betting" in seven places throughout the text.  This is a blatant, willful mischaracterization.  I challenge Ianthe Dugan to produce a single hospital throughout the country that "[bet] incorrectly that interest rates would rise" through the use of an interest rate swap.  The transactions were all reviewed and approved by the Boards serving these hospitals that are made up of local community leaders.  Does anyone really believe that these individuals, that are highly respected community members, would make a multi-million dollar "bet" that interest rates would rise?

What is a floating-to-fixed rate swap?

A floating-to-fixed rate swap is a transaction in which one counterparty (the hospital) pays a fixed interest rate and the other counterparty (the bank) pays a floating rate.  The glaring oversight that Mrs. Dugan fails to explain is that these transactions are not executed in a vacuum.  Virtually all, if not every single one, of these transactions were executed in conjunction with the issuance of floating rate debt.  When you look at the swap and floating rate debt together, the hospital is left with a "synthetic" fixed rate.  The cashflows look like this (from the hospital's perspective): pay fixed rate on swap, receive floating rate on swap, and pay floating rate on bonds.  The floating rate on the swap is structured in such a way that it is expected to equal the floating rate paid on bonds.  On a net basis, the hospital is left paying the fixed rate on the swap, which is called a "synthetic" fixed rate.

Why would anyone enter into a floating-to-fixed rate swap?

Hospitals executed these transactions because it offered a lower cost of debt.  For example, let's say that a hospital could sell a plain vanilla, 20-year fixed rate bond at 5.50%.  The hospital would be able to sell synthetic fixed rate debt at some lower cost (let's say 5.00%).  In this case, the synthetic fixed rate structure would offer 0.50% in savings versus a traditional fixed rate transaction.  So long as the floating rate received on the swap equals the floating rate paid on the bonds, the hospital is left with the synthetic fixed rate of 5.00%.  Mrs. Dugan made the argument that the transactions backfired when the Fed cut short-term rates, but that is simply untrue.  The cuts in short-term rates did cause hospitals to make net payments under the floating-to-fixed rate swaps, but this was offset by lower floating rates on the underlying bonds.

Many hospitals across the country executed these transactions and enjoyed the benefit of lower net rates.  There are, literally, hundreds of hospitals across the country that used this structure to fund projects at lower rates, which allowed them to build larger projects that provided much needed hospital beds in their communities, and spurred job creation.

What are the risks of swaps?

As is the case with any financial product, there are risks associated with them.  The majority of the problems that arose were associated with the underlying floating rate bonds, not the interest rate swaps.  Hospitals that used Auction Rate Securities ("ARS") as the underlying variable rate product suffered as a result of the ARS market failure.   In addition to the risks associated with the underlying variable rate products, there are risks associated with the "mark-to-market" of the swap.  The value of a swap changes as a result of movements in interest rates and to the extent that long-term interest rates fall, the value of the swap will be negative to the hospital.  In other words, if the hospital wanted to terminate the transaction early, they would need to make a payment to do so.  This risk was realized when hospitals with underlying variable rate products that failed had to terminate the swap before maturity.  There are many other risks associated with swaps that are beyond the scope of this article.  If anyone is interested in those, please let me know in the comments section and I will be happy to provide an article dedicated solely to the risks of swaps.

Despite these risks, there are many other hospitals with underlying floating rate debt that is still performing and they are enjoying the benefit of lower rates afforded by the synthetic fixed rate structure.  Those hospitals that did not make the WSJ article are accumulating those savings, and will ultimately invest those funds in new facilities, renovations, and other projects aimed at improving patient care.

In conclusion, these transactions were not something dreamed up by a mad scientist to dupe the hospitals across our country.  More importantly, they absolutely were not "wagers" or "bets".  They are financial products that come with risks, as well as rewards.  Articles like the one that Mrs. Duganwrote may do a good job of selling newspapers, but they paint a picture of Wall St. that is just not true.  The vast majority of Wall St. investment bankers are honest people that care deeply about their clients.  It is appalling that the WSJ would print something that is this far off the mark with an utter disregard for the reality of the situation.  Perhaps it was my own naivete to trust any source of news, but I now find myself reading everything in the WSJ with a heap of salt.  I hope more people that work on Wall St. will start standing up for themselves, and speaking out against the "Wrong-Way" journalism being perpetrated by the likes of Mrs. Dugan.

Sincerely,

Muniwiseguy

Post Script

The online WSJ article is titled "Hospitals Sue Wall Street Over Trades".  This is different than the title of the hard copy, which was "Wrong-Way Financial Bets Have Hit Hard".  Note that the count of seven references to "wagers", "bets", and "betting" was based on the hard copy version that included "bets" in the title.  The link to the online article is: "http://online.wsj.com/article/SB10001424052748704545004575353190698790172.html".

NACA Protesters Descend Upon Bear Stearns

On the morning of Wednesday, March 26th, 2008 throngs of organized protesters belonging to the Neighborhood Assistance Corporation of America ("NACA") poured into the lobby of Bear Stearns shouting slogans to employees and bystanders alike.  Participating NACA members are angry with the Fed's recent action to "bail-out" Bear Stearns and were intent on getting their message out.  Muniwiseguy was promptly on the scene a couple hours after the protest to interview members of the NACA.  After their protest at Bear Stearn's office the NACA regrouped at the side entrance of St. Bart's Church in midtown Manhattan.

"SUPPORT MAIN STREET NOT WALL STREET"

NACA members could be spotted on the scene with yellow T-shirts emblazoned with the words "Stop Loan Sharks" superimposed over the figure of a shark.  Fliers were distributed entitled "Support Main Street Not Wall Street" which criticized Bear Stearns, JPMorgan, the Federal Reserve and the Bush Administration for actions related to the housing bubble.  The NACA's message today was largely one of opposition to the specific action by the Fed to bail out Bear Stearns but it was clear after speaking to NACA members that the goals of their organization is much broader.  According to the NACA website: "The [NACA] is a non-profit, community advocacy and homeownership organization.  NACA's primary goal is to built strong, healthy neighborhoods in urban and rural areas nationwide through affordable homeownership."

Muniwiseguy was able to speak with Darren Duarte, the NACA Director of Public Affairs, who was very helpful in describing the purpose of the protest and sharing his thoughts on the real estate market in general.  Darren expressed his concern that parties involved in the mortgage market did not have the best interests of the homeowner in mind.  Mortgage brokers, investment bankers, loan servicers and rating agencies "did not have any skin in the game" according to Darren.  He believes that many of the market participants knew that the mortgage loans were going to fail but they simply didn't care. 

The recent market innovations that bifurcated the role of mortgage originator and mortgage holder have created an incentive structure that benefits mortgage originators with weaker underwriting standards.  As a mortgage broker, the upfront origination fee of 1% is going to be paid so long as the mortgage can be sold to someone else.  There was some protection against lackluster underwriting standards in the form of Early Payment Default ("EPD") provisions, which allow for contingent put rights if a certain number of mortgages within the mortgage pool experience defaults in a certain period of time (generally the first few months).  Beyond the EPD provisions, market participants had successfully divorced the role of origination, and hence underwriting, from the role of bearing credit risk.

THE NACA SOLUTION

No protester is worth his or her muster without a feasible set of solutions to the problems that he or she is identifying and speaking out against.  NACA has provided the following four point proposal to "Support At-Risk Homeowners": (i) Stop all interest rate increases; (ii) Roll back all interest rate increases to initial-qualified rate; (iii) Impose a moratorium on all foreclosures; and (iv) Restructure mortgages to affordable monthly payments.  Darren mentioned the use of a "safety and soundness directive" on the part of the Fed as the mechanism to modify the mortgage contracts.

MUNIWISEGUY OPINION

NACA is completely right to oppose the Fed bail-out of Bear Stearns.  Participants in the capital markets must realize that their actions do cause real and irreversible effects up to and including bankruptcy.  Without this specter and fear constantly reminding our bankers that risk comes with a cost, we will, in the end, subject ourselves to more destruction.  The most destructive system we could have in place is heads I win, tails the Fed loses.

While it is a noble cause to help homeowners, the solution proposed by NACA is reckless and creates a terrible moral hazard.  For starters, unless their is evidence of fraud (by evidence we are referring to specific evidence of fraud on an individual loan not a series of random anecdotes about homeowners who didn't understand the mortgage they were signing up for) it is a dangerous idea to have the Fed modifying private contracts.  If the Fed goes down this road our nation is setting a dangerous precedent.  Our public would have ceded the individual right to contract with one another by granting the Fed the ability to void our dealings based on its moral position.  The four prong solution, as put forth by the NACA, goes against our most fundamental legal and economic principles.

Beyond the moral wrongs of the four prong solution, the plan would have diametrically opposed effect of what its orchestrator intends.  In fact, the solution presented is a perfect blueprint for a policy designed to halt all mortgage lending.  By suspending foreclosures the Fed has removed collateral rights from private loans made by the mortgage holders who understood that they were buying secured loans.  What would be the result?  Market participants would realize the legal risk surrounding the mortgage collateral and price them under the assumption that they are unsecured.  Consumers are already familiar with the rates on unsecured loans with their credit cards.  Imagine how housing prices would react when you have cities with a median income of $50,000, a median house price of $500,000 and 30-year fixed rate mortgages are available at 20%.  That assumes that some lenders are left after their depressed mortgage holdings plummet even further.

The other solutions would lead to similar results although the effect would probably not be quite as detrimental as taking away the lender's collateral.  Mortgage holdings would plummet much like the previous case in which the collateral was held to be unattainable.  The remaining lenders would greatly increase their coupons on new loans because there would always be the risk that the Fed would come in later and lower coupons if people couldn't make payments.

In conclusion, we would like to speak to a moral aspect of the housing market that seems to have been glossed over by so many in the national media.  America is raising a generation of young people that will only dream about owning a house in many parts of the country.  In the New York area for example, it is hard to find a shack for under $750,000.  At the height of the bubble so many individuals felt like they would never be able to own a home if they didn't buy immediately.  In order to do so, they had to take out extremely risky loans to purchase homes that were well beyond their means. 

As with any risk there are times when it works out and times when it doesn't.  This time it didn't work out for some homeowners who took a great deal of risk and now they want to try to change the rules simply because of the result.  To grant the homeowners their wish would cause the moral hazard of a lifetime.  Patient individuals, who also wanted to purchase a home just as bad as the current homeowners, made the choice not to take out a risky loan.  A government intervention on behalf of the homeowners that took out risky loans would put homeownership out of the reach of these patient individuals who made the correct choice.  The patient individuals also have families just like the families that took out the risky loans but chose to rent.  Of course those people who had been patient would have also bought a home if they had known that the government was going to force lenders to finance it at 1% indefinitely and there was no chance of foreclosure!

Asset Liability Management for Individual Investors

ASSET ALLOCATION

When an average investor thinks of Asset Allocation he or she will generally think of some percentage of stocks, bonds, and cash.  Some of the ostensibly advanced investors will probably include other asset classes like real estate, precious metals, TIPS (Treasury Inflation Protected Securities), and possibly some other, esoteric asset classes that may be largely unavailable to the investing public.  The idea being that the larger number of uncorrelated asset classes one can add to an asset portfolio the greater the diversification benefit one achieves.  There are mountains of data supporting the benefits of diversification and it is largely accepted that proper asset allocation is more important than choosing the right assets within the asset class (i.e., deciding whether the portfolio will have 25% or 75% equities is more critical than picking Microsoft over Proctor & Gamble).  The author agrees that asset allocation is critical to the construction of an efficient portfolio.

While the purpose of this article is not to go into the gruesome details of asset allocation, it is important to touch on some of the more recent developments in the capital markets that have cast some doubt on the effectiveness of the standard mean variance approach to asset allocation.  In our standard mean variance model used to produce an optimal asset allocation, it is assumed that correlations between asset classes are static.  Correlation, for the non-statiticians out there, essentially measures whether Asset A zigs when Asset B zags.  If the two assets move exactly in the same direction over time (i.e., when Asset A increases by 1% then Asset B increases by 1%) then they would have a perfect positive correlation, which would be reflected in a correlation of "1".  On the other hand, if Asset A goes down by 1% when Asset B goes up by 1% then the two assets have a perfect negative correlation, which is reflected by a correlation of "-1".  Anything in between shows up between -1 and 1 with 0 representing a situation in which the movement of Asset A provides no information as to the movement of Asset B. 

Earlier we stated that the correlations between assets are static in our asset allocation model.  Generally the correlations assumed in the model are based on historical correlations over a given time period.  For example, if you were to examine the annual returns of large cap equities (represented by the Standard and Poor's 500) and gold over the past ten years, the data would show a mildly negative correlation between the two assets.  Given this result, it would assumed that this result would hold true over the investing time horizon and the asset allocation model would base its results off of this assumption.  One of the problems with this is that in times of severe market stress it appears that many of these historical relationships between assets breakdown.  In many of the trading sessions of the current bear market, days with sharp equity sell-offs saw simultaneous drops in gold prices.  This clearly causes problems for an investor that based his or her asset allocation on the assumption that historical assumptions would continue over the investing horizon. 

What has caused this break with historical data and what is the proper way to adjust for it?  On theory to explain this market behavior is that there is a "Margin Effect" taking place.  The idea behind a Margin Effect is that in times of market stress many of the participants, especially highly leveraged hedge funds, are going to receive margin calls on days of sharp equity sell-offs.  One could think of margin connecting different assets classes in the same way an aquifer might connect ground level lakes that are ostensibly independent of one another.  Given the high levels of leverage utilized by the hedge funds which are becoming a larger and larger driver in the market, this Margin Effect may explain some of this increase in correlation that has shown up in recently. 

Now that we have a hypothesis to explain what is causing the increase in correlations in times of market stress how does it affect our asset allocations?  One possibile solution is the use of stress tests to see how the portfolio will perform when correlations between assets are increased.  Clearly, an increase in the correlations to mimic these periods of stress will increase the modeled risk.  The model could be used to reoptimize the portfolio assuming the higher correlations and then one could take a weighted average of the original portfolio (based on historical correlations) and the reoptimized portfolio (based on the stressed correlations).  Keep in mind that the increases in correlations seen recently have not been limited to gold and equities.  There have been days in which is seems like the only asset known to man that was up were the US Treasuries.

LIABILITY ALLOCATION

Now we have come to the Liability part of Asset Liability Management.  While Asset Liability management is widespread on the corporate level, very few individuals ever give the liability side of the equation a thought.  Here is scenario that the average investor should consider.  Let's pretend that we have two investors (A and B) who are both very conservative individuals when it comes to their financial lives.  Both investors have $1MM each sitting in a savings account with their bank.  Both investors decide to purchase a vacation home in Texas for $500,000. We did say that they are conservative investors didn't we?  They could have bought the same house on one of the coasts and paid three times as much...that is a digression for a different post.  Investor A decides to lock in a fixed rate mortgage so he will always know what his payments will be.  Investor B decides to take out a variable rate mortgage because his broker talked him into it.

Which investor is in a less risky position?  To most investor's surprise, Investor B has made the less risky choice.  How can this be though?  His payments could fluctuate over time and he is old enough to remember the early eighties so he should know better.  The problem with this line of thought is that it is leaving out the other side of the equation which are the assets.  Savings deposits also fluctuate over time but Investor B will have partially hedged his deposits by matching his liabilities via a variable rate mortgage.  When short-term interest rates are high, Investor B will pay more on his mortgage than Investor A but he will also earn more on his deposits.  On the other hand, when short-term rates are low Investor B will pay less on his mortgage and receive less on his deposits.  In that scenario, Investor A will still be paying the same high fixed mortgage rate but he receives the low deposit rate.

Of course this example only worked because it was assumed that the investors had $1MM lying around in a savings account.  This will not be the case for the majority of investors but the point is for individual investors to consider both assets and liabilities when making allocation decisions.  Otherwise, a conservative investor may find that he or she is actually taking on additional aggregate risk by making conservative allocations to liabilities without taking into consideration assets.

Municipal Auction Rate Securities

THE CURRENT AUCTION RATE SECURITIES MARKET

The Auction Rate Securities ("ARS") market has been experiencing an unprecedented breakdown in liquidity via massive failed auctions.  These auction failures have resulted in the ARS resets to leap to the penalty rates as high as 15% for some issues.  Bondholders of a failed auction are unable to sell their securities through the normal auction procedure.  For many of the bondholders, that desperately need access to cash, the high rate received under the failed auction is bittersweet because they cannot recover their principal.  For other investors that do not need cash right away, these developments have proved to be a boon as they are achieving an outstanding return on capital for, in most cases, little credit risk.

WHAT IS THE COST TO TAX-EXEMPT ISSUERS?

The malaise in the ARS market threatens to cost tax-exempt issuers hundreds of millions of dollars per month if current market conditions persist.  While there are varying reports on the exact size of the tax-exempt ARS market, the total ARS market (i.e., taxable AND tax-exempt) is estimated at $330 billion.  Making a conservative assumption that only half of the ARS market is tax-exempt would imply $165 billion of these toxic variable rate securities.  For every point (1%) that the yield of the ARS increases, the tax-exempt issuers are out $1.7 billion annually ($138 million per month). 

In order to appreciate the scope of the problems in the ARS market it is important to understand the alternatives available to tax-exempt issuers.  Variable Rate Demand Bonds ("VRDBs") are a common type of variable rate bond issued in the tax-exempt market and are a viable alternative to ARS for most issuers.  The ARS market developed rapidly over the past five years but is nascent compared to the VRDB market which has been around since the mid 1980s.  The SIFMA ARS Index (a weekly tax-exempt variable rate index that tracks the ARS market) has averaged 3.76% over the past four resets while the SIFMA Swap Index (a weekly, tax-exempt variable rate index that tracks the VRDB market) has averaged 2.80%.  This spread of 0.96% (SIFMA ARS Index less SIFMA Swap Index) is a good measure of the relatively higher cost of ARS to other variable rate alternatives for tax-exempt issuers.  There are other factors that also play into the net cost to issuers such as the ongoing support fees associated with the different variable rate products (e.g., broker-dealer fees, liquidity fees, remarketing fees).  Under current market conditions, assuming an insured variable rate bond offering, the fees associated with VRDBs would be higher by approximately 0.15% to 0.25%, which would cut into the 0.96% benefit calculated earlier.  With the adjustment for the support fees included the ARS market appears to be costing tax-exempt issuers 0.71% to 0.81% which equates to $1.2 to $1.3 billion annually ($98 to $112 million monthly).

WHAT CAUSED THE PROBLEMS IN THE ARS MARKET?

Whenever money is lost, and especially when a great deal of money is lost, our petulant society is quick to seek an outlet for its wrath.  Who is responsible for the frozen ARS market?  Is there someone that was too greedy and now needs a good thrashing?

The ARS market freeze was not caused by a single event or a single firm.  There were, in fact, a few major events occurring simultaneously that resulted in the dire market results.  Those were:

1) Loss of Faith in Monoline Insurers
The ARS market has always been a highly credit sensitive place.  Well over 90% of all ARS issues were AAA rated prior to the faltering of the insurers.  Insurance was almost a requirement for issuers with only a few highly rated entities entering the ARS market without the support of a monoline insurer.  The loss of faith in the insurers would have had a major detrimental effect on the market even if none of the other events listed below occurred.

2) Broker-Dealer Writedowns and Losses
It was standard practice for broker-dealers to use proprietary accounts to place bids in order to avoid failed auctions.  This practice is described in the May 31, 2006 SEC settlement with 15 of the broker-dealers that participate in the ARS market (the news release can be seen here http://www.sec.gov/news/press/2006/2006-83.htm).  The ARS market appeared to be more stable than it actually was.  The writedowns and losses affected the market by eventually preventing the broker-dealers from bidding on the auctions to prevent their failure.  As the credit crises worsened, the broker-dealers no longer had an adequate balance sheet to bid on the auctions and they were forced to watch them fail.

3) Cash is King
The general effects of the credit crises eventually came to bear down on the short-term municipal market.  Many corporations invested heavily in the ARS market as a place to park their cash.  Given the rarity of failed auctions prior to the credit crises, the ARS investors were comfortable with the auction procedure as a source of liquidity.  Even though the ARS lacked a hard put like a VRDB (VRDBs can be put back to the issuer on any interest payment date by the investor at par), ARS investors accepted lower rates on their than a VRDB from the same issuer.  As the credit crises progressed the corporate money managers began to feel the strain of the corporation's need for cash.  Once the first few auctions failed there was a panic amongst these buyers and everyone was running for the exits only to find the doors chained shut.